How the State and Local Tax Deduction Influences State Tax Policy

Much ink has been spilled on the state and local tax deduction, an important tax reform “pay-for” that narrowly survived tax reform in 1986 and is now very much on the table in 2017. In the past, we have explained how the deduction subsidizes higher state and local taxes and why the provision isn’t necessary to prevent double taxation. It is instructive, however, to look at what state governments say about the interplay between the deduction and state policy.

When the advocacy group “Raise Up Massachusetts” submitted a “millionaires’ tax” constitutional amendment, the Massachusetts Department of Revenue’s economic impact analysis included the following as worthy of consideration on resulting tax burdens:

“Offsetting impact to Massachusetts taxpayers of Federal deduction for state income taxes: Since state income taxes are generally deductible against Federal income taxes, those paying more state income taxes under the proposal would generally see their federal income taxes lowered. These federal offsets are estimated to be between $0.4 billion and $0.8 billion with a mid-point of $0.6 billion in tax year 2019.” [Emphasis mine]

And when Governor Bill Walker (I) of Alaska opted to pursue a state income tax last year, he was sensitive to the role of the state and local tax deduction:

“We selected an income tax over a sales tax for a couple of reasons. We wanted out-of-state workers who commute back and forth to Alaska to contribute to the solution. We also were sensitive to local governments that already have a sales tax. We didn’t want to stack a state sales tax on top of a local sales tax. State income taxes are deductible from your federal taxes. And an income tax is less costly and burdensome to collect than a sales tax.” [Emphasis mine]

The state and local tax deduction makes tax increases less expensive than they would otherwise, as a portion of the cost is exported to other taxpayers across the country. It also favors some tax types over others, encouraging states and localities to load up on deductible general taxes even if, for instance, a more fee-for-use system would make greater sense to pay for some services.

Under the state and local tax deduction, taxpayers who itemize on their federal tax return can generally deduct their property taxes plus either their state and local income or sales taxes. The income tax deduction is necessarily more substantial, and it encourages states to lean more heavily on income taxes even if they might otherwise favor a different tax mix.

In short, in addition to its many other flaws, the state and local tax deduction helps drive state and local tax decisions in directions they might not go absent a thumb on the scale. That’s yet another reason to see its repeal as an attractive pay-for in federal tax reform.

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